Warren Buffett on Inflation — Part 2
Inflation took the auto insurance industry by surprise in the 1970s.
Introduction
In part one of this series, I looked at Warren Buffett’s final partnership letters to gain insight into his views on bonds in early 1970. As the Buffett Partnership wound down, partners received cash distributions that needed to be invested. Mr. Buffett provided a detailed letter that served as a tutorial on the mechanics of fixed income investing as well as a practical strategy for partners who planned to purchase bonds at that time.
In 1970, it was possible to earn seemingly attractive tax-exempt yields of ~6.5% on twenty year municipal bonds. This was far more generous than investors had been accustomed to in the recent past. In addition, the spread between municipals and treasuries was unusually narrow. Yields continued to rise in the months following Mr. Buffett’s letter but, after topping out at 7.1% in May 1970, municipal bonds did not offer comparable yields until December 1974, as we can see in the exhibit below:
Few investors anticipated double-digit inflation during peacetime. Inflation hit 11.1% in 1974 and, after a brief respite of single-digit inflation from 1975 to 1978, double-digit inflation returned with a vengeance from 1979 to 1981. This was a brutal period for bond investors as inflation eroded the purchasing power of coupons and principal. Although inflation finally came down in the 1980s, the buyer of a 6.5% tax-exempt twenty year bond in 1970 barely treaded water if he held until maturity in 1990.
As the 1970s progressed, Warren Buffett frequently discussed inflation in his annual letters to shareholders. In this article, I’ll discuss the effect of unanticipated inflation on the automobile insurance industry.1 In the final installment of this series, planned for early next week, I will discuss Mr. Buffett’s views on the advantages of capital-light business models, such as See’s Candies, during times of rapidly escalating prices.
Home and Automobile Insurance Company
In September 1971, Berkshire Hathaway acquired Home & Automobile Insurance Company which specialized in writing auto insurance in Cook County which includes Chicago and nearby suburbs. The company was founded by Victor Raab soon after he returned from serving in the United States Army in the Second World War.2 By 1971, the company was writing $7.5 million in premium volume, the equivalent of $56.4 million in 2023 dollars.3 Although the purchase price is not known, Warren Buffett was willing to pay a $364,000 premium over the net assets of the business.4
Berkshire Hathaway added capital to Home & Automobile Insurance Company that allowed it to establish branch operations. The company was known for “its highly-concentrated and on-the-spot marketing and claims approach” and Warren Buffett hoped to extend this strategy to “other densely populated areas.” After a successful 1972, Berkshire made plans to expand into Dade County, Florida and Los Angeles, California in 1973, with further expansion planned within a few more years.
High inflation was the primary cause of “very poor” results in 1973 for auto policies in the Chicago area. Although high energy prices resulted in less driving and lower accident frequency, this was more than offset by higher than expected inflation in medical and repair costs. In addition, jury awards were higher than expected. While Mr. Buffett struck a cautious tone in the letter, he noted that competitors were more optimistic, implying that he expected inadequate rates to persist during 1974.
Inflation skyrocketed from 6.3% in 1973 to 11.3% in 1974, representing the highest rate of inflation since 1947.5 After years of unusual profitability in the insurance industry, “unintelligent competition with consequent inadequate rates” combined with rising prices to deliver a 111% combined ratio6 for all of Berkshire’s insurance operations.7
Warren Buffett estimated that costs of auto repair and medical payments were rising at the rate of 1% per month on average as “inflation grinds very heavily” but auto insurance premiums in the United States rose by only 2% for all of 1974! When Mr. Buffett wrote his 1974 letter in early 1975, conditions were still deteriorating.
Home and Automobile Insurance Company’s foray into Florida “proved disastrous” with underwriting losses in that market coming in at over $2 million. Berkshire withdrew from Florida in mid-1974 but losses continued to develop. Rates in Chicago were also inadequate causing Berkshire to increase pricing at the cost of a significant drop in premium volume. It was imperative to limit losses in order to preserve capital that would fund significant growth in the future “when conditions become right.”
In 1975, Home and Automobile Insurance Company operated only in the Chicago area but results were still “very bad” which resulted in new management that “completely revamped” underwriting. Reading between the lines, it appears that Victor Raab’s knowledge of the Chicago market could not be replicated in Florida and inflation also caught him off guard. Mr. Raab, who was previously described in glowing terms, is never mentioned again in Mr. Buffett’s letters to shareholders.
In addition to the direct effect of rising prices, a portion of the 1974 letter is devoted to the problem of “social inflation” which arises when lawsuits expand coverage beyond limits management contemplated when rates were set. The insurance group as a whole posted a horrendous statutory combined ratio of 117.8% in 1975.8 Scarred by several years of unsatisfactory results, Mr. Buffett forecast a “substantial gain” in premium volume during 1976 due to rising rates rather than writing more policies.
Under new management, the Home and Automobile Insurance Company experienced a “strong recovery” in 1976. In order to respond more closely to inflationary trends, the company shifted to a six month policy billing cycle. The combined ratio for the auto insurance business was not specified but the overall insurance group actually posted underwriting profits for 1976 with a 98.7% combined ratio.
The skies were mostly clear in 1977, but there were ominous clouds on the horizon:
“In 1977 the winds in insurance underwriting were squarely behind us. Very large rate increases were effected throughout the industry in 1976 to offset the disastrous underwriting results of 1974 and 1975. But, because insurance policies typically are written for one-year periods, with pricing mistakes capable of correction only upon renewal, it was 1977 before the full impact was felt upon earnings of those earlier rate increases.
The pendulum now is beginning to swing the other way. We estimate that costs involved in the insurance areas in which we operate rise at close to 1% per month. This is due to continuous monetary inflation affecting the cost of repairing humans and property as well as ‘social inflation’, a broadening definition by society and juries of what is covered by insurance policies. Unless rates rise at a comparable 1% per month, underwriting profits must shrink. Recently the pace of rate increases has slowed dramatically, and it is our expectation that underwriting margins generally will be declining by the second half of the year.”
Insurance is cyclical and the pattern described in this section is not abnormal. Periods of high underwriting profitability create incentives to write more policies and this can sow the seeds of losses in the future. During the early 1970s, rates were most likely set with the expectation that the status quo of low to mid-single-digit inflation would persist. But when inflation hit 11.1% in 1974 and remained high at 9.1% in 1975, premiums could not cover rising repair and medical costs, not to mention the pressure of “social inflation”, and underwriting losses ensued.
Problems at GEICO in the mid-1970s
In his 1977 letter to shareholders, Warren Buffett disclosed Berkshire’s investment in convertible preferred and common stock of GEICO, an auto insurer that Mr. Buffett had been familiar with for more than a quarter-century. He outlined the basic business model of GEICO in The Security I Like Best published on December 6, 1951 in The Commercial and Financial Chronicle. At the time, the auto insurance industry was dealing with recovering from losses brought about by postwar inflation:
“Auto insurance is regarded as a necessity by the majority of purchasers. Contracts must be renewed yearly at rates based upon experience. The lag of rates behind costs, although detrimental in a period of rising prices as has characterized the 1945-1951 period, should prove beneficial if deflationary forces should be set in action.”
It’s remarkable how many of GEICO’s advantages cited by Mr. Buffett in an article written nearly seventy-two years ago still hold true today. However, one difference between 1951 and the mid-1970s is that GEICO remained highly profitable. During the first half of 1951, GEICO’s underwriting margin was 9%, which is the equivalent of a 91% combined ratio. Nearly all other insurers had underwriting losses. The article went on to note Benjamin Graham’s role as Chairman of the Board due to his large ownership interest and noted that the stock traded at eight times 1950 earnings.
Unfortunately, GEICO’s results during the inflationary period of the mid-1970s was far worse than its results of the early 1950s. GEICO reported an underwriting loss of $140 million in 1975 compared to a $26 million profit in 1974. The main culprit was that rates were inadequate and failed to account for double-digit inflation.
By the end of 1975, GEICO’s ratio of premiums-in-force to capital was roughly 9 to 1, far above the 3 to 1 ratio that regulators typically mandated. GEICO was in a precarious financial position. Jacob McDonough’s 10-K podcast recently released episodes on GEICO’s 1974, 1975, and 1976 annual reports which go into much detail on what went wrong at the company and I recommend listening to the episodes.
As of December 31, 1977, Berkshire Hathaway owned $33 million of GEICO convertible preferred stock and $10.5 million of common stock for a total of $43.5 million invested in the company with a cost basis of $23.5 million. The investment in GEICO accounted for 24% of Berkshire’s equity portfolio.
Eighteen years later in his 1995 letter to shareholders, Warren Buffett took a trip down memory lane recounting his involvement in GEICO dating back to 1951, even going so far as to call GEICO “his first business love”. A portion of the letter is worth excerpting at some length:
In the early 1970's, after Davy retired, the executives running GEICO made some serious errors in estimating their claims costs, a mistake that led the company to underprice its policies - and that almost caused it to go bankrupt. The company was saved only because Jack Byrne came in as CEO in 1976 and took drastic remedial measures.
Because I believed both in Jack and in GEICO's fundamental competitive strength, Berkshire purchased a large interest in the company during the second half of 1976, and also made smaller purchases later. By yearend 1980, we had put $45.7 million into GEICO and owned 33.3% of its shares. During the next 15 years, we did not make further purchases. Our interest in the company, nonetheless, grew to about 50% because it was a big repurchaser of its own shares.
Then, in 1995, we agreed to pay $2.3 billion for the half of the company we didn't own. That is a steep price. But it gives us full ownership of a growing enterprise whose business remains exceptional for precisely the same reasons that prevailed in 1951. In addition, GEICO has two extraordinary managers: Tony Nicely, who runs the insurance side of the operation, and Lou Simpson, who runs investments.
We again see the tendency of insurance executives to make rosy assumptions when it comes to claims costs which leads to inadequate pricing. Usually, this is driven by a desire to maintain market share at almost any cost. In the 1970s, GEICO’s overly aggressive assumptions for claims costs combined with unexpected inflation that took the entire industry by surprise resulted in near disaster. However, the fundamental advantages at GEICO were intact leading Mr. Buffett to hit a home run.
Parallels to the Early 2020s
“What has been is what will be, and what has been done is what will be done; and there is nothing new under the sun.” — Ecclesiastes 1:9
By 2020, Warren Buffett had followed GEICO for seven decades and had directly participated in the insurance industry for fifty-three years. He observed GEICO’s problems with inflation in the early 1950s and again in the mid-1970s. Through countless communications to shareholders, and no doubt internally to Berkshire’s managers, Mr. Buffett had stressed the importance of adequate policy pricing and the virtue of being willing to give up market share in exchange for avoiding losses when competitive pricing is clearly inadequate.
I’ve written about GEICO frequently over the past three years, mostly in the context of competitive pressures brought about by the pandemic and the subsequent inflation. The insurance industry initially benefited greatly from the fact that miles driven plummeted during the lockdowns of early to mid-2020. This windfall was soon offset by rebate programs intended to compensate policyholders who were driving less. Unexpectedly high inflation soon took its toll as medical and repair costs rose faster than premiums were rising. Underwriting losses soon followed.
Is this creating a sense of déjà vu yet?
My most recent articles covered the ongoing competition between Progressive and GEICO and provided an overview of GEICO’s results since Q1 2020. I won’t repeat the analysis and discussion in this article, but suffice it to say that while the pandemic was unique, the toll that the industry took due to unexpected inflation has been seen many times before. In the case of GEICO, this resulted in six straight quarters of underwriting losses from Q3 2021 to Q4 2022.
At the 2023 annual meeting, Vice Chairman Ajit Jain indicated that GEICO was expected to post a combined ratio of just under 100% for the full year and that he anticipated a combined ratio of 96% within two years. Of course, management has made certain assumptions regarding the trajectory of inflation from this point forward and time will tell whether rates are now truly adequate.
Conclusion
Along with many other pernicious effects on the economy, unanticipated inflation wreaks havoc in the insurance industry. Rates are set before costs are known and all cost estimates depend on future inflation. It is understandable why insurance executives ran into problems in the mid-1970s since few observers expected peacetime inflation to reach double-digits. In response, executives had to decide between raising rates and potentially sacrificing market share or accepting underwriting losses.
In the case of GEICO, the results were nearly catastrophic but opened the door for Berkshire Hathaway to make a large investment in the business that eventually grew to a fifty percent position before the other half of the business was acquired in 1995. For Berkshire’s Home and Automobile Insurance Company subsidiary, the results were unpleasant but never threatened the solvency of the overall corporation. Aside from inflation, Berkshire learned that in-depth familiarity with the peculiarities of one market, Chicago, was not easily transferable to distant markets such as Florida.
Despite living through multiple insurance industry cycles and many bouts of inflation over a long career, Warren Buffett could not avoid the effects of rapid inflation in the post-pandemic period. Although Mr. Buffett does not personally manage GEICO, he has long instructed insurance managers to reject inadequate pricing even at the expense of giving up market share. Despite these instructions, GEICO still suffered underwriting losses for over a year. Such periods of adversity are par for the course in the insurance business. What is important is to stay in the game in the long run, preserving capital for when the cycle turns and rates are again attractive.
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For this article, I worked primarily from the compilation of letters published as an ebook since it is searchable and includes letters from 1965 to 2022. Berkshire’s website includes shareholder letters from 1977 to 2022 and annual reports from 1995 to 2022.
Victor Raab died earlier this year at the age of 99.
Estimated using the BLS CPI Inflation Calculator from August 1971 to August 2023.
The Complete Financial History of Berkshire Hathaway by Adam Mead, p. 63.
The combined ratio of an insurer is the sum of losses and underwriting expenses divided by earned premiums. A combined ratio of 100% indicates breakeven results whereas a ratio under 100% indicates underwriting profitability. In addition to representing underwriting losses, a combined ratio far above 100% could indicate overall losses for an insurer even after taking investment income on policyholder float and shareholders’ equity into account.
The Complete Financial History of Berkshire Hathaway by Adam Mead, p. 74
The Complete Financial History of Berkshire Hathaway by Adam Mead, p. 103.
I just love coming across your articles during my research. It was great to read a bit more about Victor Raab. Buffett had a good judgment of character in the early days.